Central Banks Look Set to Lengthen the Good Times

They're not certain to make the right choices, but the world's central bankers are using new freedoms to follow the model that's helped extend the U.S. boom.
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When the

Bank of England

raised interest rates a few weeks back, it raised more than a few hackles as well. Industry leaders decried the rate rise as unnecessary. From somewhere on the back benches,

Ken Clarke

, chancellor of the exchequer in the

John Major

government, chimed in. The left-leaning

Guardian

ran editorials with such headlines as "Shock therapy that feels a little like panic."

But economists nodded approval. Though none had forecast the bank would tighten, it was not for thinking that it

should

not raise rates, but that it

would

not. Inflationary pressures are building, but inflation itself is low in the U.K., running at its lowest rate in 36 years as measured by the August

consumer price index

(released about a week after the rate hike). Britain's newly independent central bankers are apparently ready to move much more pre-emptively than in the past.

It may be that the new environment at the Bank of England turns out to be the rule rather than the exception. The

Federal Reserve

already established a reputation of moving pre-emptively in 1994, when a series of rate hikes brought the U.S. economy in for a soft landing. The

Bank of Japan

, like Britain's central bank, has recently been freed from government meddling. Whereas many European central banks were not independent, the

European Central Bank

is.

What's more, with inflation tamed in the major industrial countries, central banks have got the leeway to be more forward looking than ever before. As a consequence, argues

Salomon Smith Barney

European economist Jose Luis Alzola, the interest-rate cycle will be less wide than before and economic upturns will lengthen. While some profess amazement over the U.S.' 102-month expansion -- already the longest peacetime expansion and on track to be the longest in history -- it may be that such long cycles will become

de rigueur

.

Besides drawing out economic cycles, such an environment would also make the world better able to handle economic shock. "If price stability has been achieved, and central banks don't have to fight inflation," says Alzola, "they can afford to be more proactive when there is a crisis. They have more maneuvering room."

Longer upturns. A global economy better able to resist shock. With it comes the suggestion that the risk premiums associated with stocks and long-term bonds should be lower. Yield curves can flatten out and stocks -- particularly cyclical and interest-rate-sensitive issues -- can safely carry valuations above historic norms. Not a bad world to be in.

But it's also something of an imaginary world, presupposing that central banks, given the opportunity to act more pre-emptively, will do the right thing. To believe that we are in a new era of central banking "crucially assumes the pre-emptive move is the correct move," says Jeffrey Applegate, chief investment strategist at

Lehman Brothers

. "Just because it's pre-emptive doesn't mean it's right."

It is a new game for central banks, after all, and just because the Fed was so successful once doesn't mean that such successes can easily be repeated. For all we know,

Alan Greenspan

threw boxcars when he cooled the economy in 1994. Moving on the basis of leading economic indicators is, after all, "a bit of a gamble, because you're acting on information that is suggesting what will happen," says Kevin Flanagan, money market economist at

Morgan Stanley Dean Witter

.

Yet importantly, these criticisms do not counter the fact that central banks are operating in something of a new environment. No doubt it's foolish to assume that bankers will systematically make the right decisions, but it means something that they are better able to move against threats to prolonged economic growth.